China’s economic reform policy was instituted at the Third Plenary Session of the 11th Central Committee of the Communist Party of China in December 1978. A “gradual” reform strategy was adopted (as opposed to the “big-bang” approach app lied in some East European countries). Agriculture was the first area in which China implemented reforms. The results were clear: agricultural output increased by 67% between 1978 and 1985, and productivity (measured as the amount of output for a given amount of inputs) increased by nearly 50%, in contrast with no increase n productivity over the previous s two and half decades (Lin, 1992; McMillan e t al. 1989).

The increase in agricultural productivity in turn spurred the growth of rural enterprises, or Township village Enterprises – TVEs, by generating a pool of savings and excess labour (Byrd and Lin, 1990). Beginning from a small base, TVEs were allowed to grow with few of the restrictions that hobbled state-run industries and TVE s expanded rapidly. A number of studies have recently been done to explain the success of TVEs (e. g. , Weitzman and Xu, 1994; Chang and Wang, 19 94; Li, 1995).

Industrial reforms were begun in 1979 and reaffirmed at the Third Plenary Session of the 12th Central Committee of the Communist Party of China late in 1984. The thrust of this reform program was to transform thousands of large- and medium-size SOEs into profit-seeking economic units in a market economy. A popular official slogan was that “the goal of the SOE reform is to make enterprises independent, autonomous and responsible for profits and losses. ” Accordingly, there forms involved an evolutionary process of re-assignment of decision rights and residual claims from the state to members within the enterprise (i. . , the manager and workers).

The argument for shifting decision rights to the manager of the firm was based on the assumption that managerial decisions are more efficiently made at the firm level than at the central planner level owing to information/communication problems. While the theoretical legitimacy of this assumption dates at least back to Hayek (1945), Chinese economists were mainly basing their argument on the observed poor performance of its central planned system (Zhang, 1996).

In particular, the rational for shifting residual claims to the members of the firm was based on incentive considerations. Although modern theory of incentives was just recently introduced into China, pre-reform Chinese experience seemed sufficient for both Chinese economists and reform-minded political leaders to understand how essential an incentive system is for economic performance. State-owned enterprises are the natural focus of any effort to evaluate the progress of China ‘s industrial reforms. Indeed, SOE reform has been the central component of China’s overall reform package since the early 1980s.

The dominant view among Chinese economists is that SOE reform has not been very successful, at least in terms of profit (Zhang, 1996). The number of SOEs running at a loss has be en rising, and the amount of loss has been increasing. In 1993, for instance, total losses from state-owned industrial enterprises were 45. 3 billion yuan (RMB), about 14 times losses in 1985. Due to wide scope and huge amount of losses in the state sector, government subsidies to SOEs also swelled, taking a 37% jump from 1986 to 1992.

Furthermore, SOEs’ contributions to government revenues have be en declining. The ratio of profit plus tax over sales revenues for the SOEs dropped from 26% in 1 980 to 12% in 1992 (Lin, 1996). Studies by western economists, focus mainly on the effects of reform on total factor productivity (TFP) growth in Chinese state enterprises. The results have been mixed. Woo, et al. (1994), for example, found that, in the 1984-1988 period, TFP growth in SOEs was zero at best.

This is in contrast to several other studies (Chen, et al. 1988; Jefferson, Rawski and Zh eng, 1992; World Bank, 1992; Gordon and Li, 1995), that found significant impro vements in SOE s’ productivity. Their estimates of annual TFP growth in the 1980s range from 2 to 4%, compared with almost zero percent growth prior to the reforms. From the social perspective, the increase in SOEs’ TFP indicates the success of SOE reform. But the government, as the owner of the SOEs, does no t seem to directly benefit from the reforms The improvement in productivity and the decline of profits may be reconciled, however.

As indicated above, SOE reform can be characterized as a process of re-assignment of decision rights and residual claims from the state to the members of the enterprise. This improves the incentives for managers and workers to improve efficiency and pursue profits. However, managerial discretion associated with managerial decentralization may be abused such that managers become actual residual claimants, even though the state is the legal residual claimant of the enterprise.

Mo re specifically, SOEs are owned b y the state but run by managers and workers. Due to asymmetric information and high monitoring costs, managers might reduce the profits submitted to the state by overstating costs and/or underreporting revenues. Although managers cannot easily pocket the profits, they have many opportunities to spend the enterprise’s money. As a result, we see an improvement in SOEs’ efficiency on the one hand, but a decline in profits in official statistics on the other.

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